Yesterday, we went over some of the basics of REITs, and discussed some of the advantages and drawbacks of these unique investment entities. In our article, we mentioned that REITs usually specialize in a particular segment of the real estate industry; we also mentioned that REITs can operate under different corporate structures, including publicly traded, public non-traded, and so forth. One unique REIT structure is the UPREIT, which stands for “Umbrella Partnership Real Estate Investment Trust.” UPREITs offer a special opportunity for real estate investors to acquire ownership shares without investing cash. In this article, we will discuss the basics of UPREITs and then mention how these structures intersect with property acquired in a 1031 exchange.
Basics of UPREITs: Property Contributions for Ownership Shares
Most REITs focus on a narrow segment of the real estate industry, such as hotels or apartment complexes. What makes an UPREIT unique is the way in which investors acquire shares of ownership. Traditionally, investors buy shares in REITs using cash, just as they would if they purchased stock in a corporation. But, in an UPREIT, investors who already own real estate investment property contribute their property to the UPREIT portfolio in exchange for shares. Although many might suppose that this type of exchange would constitute a taxable event, this contribution of property in exchange for shares is usually capable of being done in a tax-deferred manner under Section 721 of the IRC.
The Use of UPREITs with 1031 Exchange Property
One big benefit of UPREITs is the fact that investors have the opportunity to contribute real estate which was acquired in a 1031 exchange. This means that investors can take advantage of two very powerful tax code provisions, back to back. Here’s how this can be done: first, the investor conducts a 1031 exchange and acquires suitable replacement property. Then, the investor satisfies the “holding period” by establishing a clear intent to hold the replacement property for business or investment purposes. Next, after the holding period has been fulfilled, the investor contributes the replacement property to an UPREIT in exchange for shares of ownership.
In this scenario, it is imperative that investors do what is necessary to firmly establish that they have an intent to hold the replacement property for investment before making the contribution. The IRS scrutinizes both 1031 exchanges and exchanges made under Section 721, and if the IRS thinks that they can challenge the exchange on the basis that the holding period wasn’t fulfilled, the IRS will likely do so. Before attempting to contribute a 1031 exchange replacement property to an UPREIT, you would be well advised to discuss the matter with an experienced tax attorney. This will ensure that everything is done properly.
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